Probably, the most significant and efficient estate and gift tax planning strategies include freezing or stabilizing the value of what’s owned by the most senior generation of a family, all the while deflecting growth to younger generations, or changing the nature of what a taxpayer owns in a manner so as to reduce its value for tax purposes. A popular method of freezing value was to form an entity (typically, a partnership) under which the senior members of a family would acquire and hold the preferred interests, whose value would tend to be stabilized, and for junior members to acquire the common interests, which were expected to grow in value. A common way to change the nature of what’s owned and, therefore, reduce its value has been to transfer interests into a private, family controlled entity, such as a partnership, often called a “family limited partnership” (FLP), or to a family limited liability company.
History of Freeze Restrictions
Effective Oct. 9, 1990, Internal Revenue Code Sections 2701 through 2704 were enacted to prevent the reduction of taxes through the use of “freezes” and other arrangements designed to reduce the value of the transferor’s taxable estate or gifts and discount the value of the taxable transfer to the beneficiaries of the transferor without reducing the economic benefit to the beneficiaries. Generally, IRC Section 2704(b) provides that certain “applicable restrictions” (that would typically justify discounts in the value of the interests transferred) are to be ignored for purposes of valuing interests in family-controlled entities, if those interests are transferred (either by gift or on death) to or for the benefit of other family members. An applicable restriction, essentially, is one that restricts the ability of a partnership or corporation to liquidate with terms that are more restrictive than under applicable default state law and that either disappears after the transfer to a family member or the family has the collective capacity to eliminate it. To avoid a restriction being an applicable one, state laws have been changed so the default rules of state law restrict the ability of the entity to liquidate. In addition, small interests in the entity are sometimes given to non-family members so the family can’t remove a restriction that’s been placed on the entity with respect to liquidation. For example, in Kerr v. Commissioner,1 the U. S. Court of Appeals for the Fifth Circuit affirmed a Tax Court decision that the restriction on a partner’s ability to liquidate the partner’s interest wasn’t an applicable restriction (which would be ignored under Section 2704(b) for valuation purposes). The Court of Appeals held the “restriction” wasn’t an “applicable restriction” because liquidation required the consent of a minor non-family member partner.
Additional Category of Restrictions
To combat those end runs around Section 2704(b), legislation has been proposed that would create an additional category of restrictions (disregarded restrictions) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the family if, after the transfer, the restriction will lapse or may be removed by the transferor and/or the transferor’s family.2 Specifically, the transferred interest would be valued by substituting for the disregarded restrictions certain assumptions to be specified in regulations. Disregarded restrictions would include limitations on a holder’s right to liquidate that holder’s interest that are more restrictive than a standard to be identified in regulations. A disregarded restriction also would include any limitation on a transferee’s ability to be admitted as a full partner or to hold an equity interest in the entity.
However, the 2014 and 2015 Greenbooks dropped this legislative proposal. It’s understood that the proposal was dropped because the Treasury intends to issue regulations that would produce the same type of result. And, it seems like the Treasury has the power to do so. Section 2704(b)(4) provides, “The Secretary [of the Treasury] may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.” This grant of legislative regulatory authority is so broad, it’s questionable whether any such regulation would be struck down as invalid.
It’s possible that actual operating companies will be exempted from the forthcoming regulations, while holding entities (for example, a typical FLP) would be covered. So, for example, if a brother and sister own a car dealership, discounts would be allowed. But, if they form a FLP that holds, for example, marketable securities, hedge funds and other portfolio type investments, the discounts would be denied. Perhaps, the regulations will rely on the distinction made under Section 6166 (relating to the deferred payment of estate tax on certain active closely held enterprises) between active companies and ones that are just holding entities.
It’s possible that many taxpayers (or their families) would benefit from any such new regulations. That’s because the property will be worth more at death without discounts meaning a higher “step up” in basis under Section 1014.
In any case, it seems appropriate for lawyers, CPAs and other financial advisors to contact their clients about this potential development and discuss what action should be taken. If discounts could be an important factor in achieving estate and financial plans, it may be that prompt action will be required. Although the effective date of any such regulations is uncertain, it’s likely that only transfers that are completed prior to the effective date (for example, completed gifts of partnership units or sales of them) will be grandfathered from the new rules.
For an interview with Jonathan G. Blattmachr on the anticipated regulations, click here
- Kerr v. Commissioner,1 292 F.3d 490 (5th Cir. 2002).
- See, e.g., U.S. Treasury Greenbook proposal for 2013, www.treasury.gov/resource-center/tax-policy/Pages/general_explanation.aspx.
Jonathan G. Blattmachr is the Director of Estate Planning for the Alaska Trust Company. He is also co-developer of Wealth Transfer Planning a computerized system for lawyers, and a Director at Pioneer Wealth Partners LLC in Manhattan. Matthew D. Blattmachr is a Vice President and Trust Officer at Alaska Trust Company.